Overheads

Understanding accounts series

Introduction

Overheads, our topic in this factsheet, are one of the most diverse and yet at the same time one of the simplest and most accessible areas. They require only a knowledge of how businesses work.
First of all, this section of the profit and loss account has many names. It is seldom called Overheads, usually being referred to as Expenditure or Fixed costs (not to be confused with Fixed assets) or even Running costs or Indirect costs. Each is valid and correct and in some ways more explanatory than “overheads”.
So here is fundamental fact number 1: Usually the thing which most affects these costs is TIME.
Let’s look at the other names now.
Fixed costs:
Suggests that the amount never changes from year to year. That would be great except that it is unrealistic. The fixed nature of these costs is their presence in the business. An example will make this clear.
One type of fixed cost is rent or rates. In deciding to occupy an office or factory for a period of years, the cost of rent will be in your accounts for that period and there is little you can do to change the amount of the rent or rates. In that sense, then, rent is a fixed cost – it is going to be there for a number of years.
Naturally if you occupy the property for less than a year, the amount you pay will reduce. It is in this way that TIME affects overhead expenses.
A business that in its first trading period is in existence only for eight months cannot expect its overhead costs to be at the same level in year two since, in year two, it will have been trading for 12 months. So if overheads in total for the first trading period are £16k, we might expect overheads in year two, a 12-month period, to be closer to £24k (16k x 12 months/8 months).
Indirect costs:
In this case means not directly (indirectly) connected with sales. In other words, if sales increase or reduce from a standard, overheads won’t automatically change proportionately with sales. That kind of reaction occurs with direct costs or the costs included in cost of sales.
A good example to demonstrate this is wages.
If a company has £250,000 of sales and it costs £50,000 for wages and then increases sales by £25,000 (10%), it doesn’t follow that wages will increase by 10%. The extra sales may be produced on overtime or by engaging lower cost labour and so wages may rise by only £3k or £4k instead of the full £5k (10%). This characteristic also proves that wages, in this scenario, are indirect costs or overheads.
Finally, running costs:
This descriptor gives a clue about the kinds of costs to be found in overheads, those affecting the running of the business rather than the trading activity. So they will include rent and rates, heat and light, advertising, telephones, stationery, depreciation, accounting fees, entertainment etc.
The list is almost endless and cannot be specified precisely – it depends on the business, how it operates and where, and what it’s overheads are.

How do we measure business performance on overheads?

The most usual way is to calculate the overhead spend as a percentage of sales. It has the advantage of being easy and able to be automated using spreadsheets. Sage uses this method in its variance report and prior year report.
Here’s an example:

Year 1

Year 2

Year 3

Sales

100

150

200

Overheads

30

40

55

Overheads %

30.0%

26.7%

27.5%

So even when sales are rising as they are in this example, we should still be trying to control overheads so they don’t exceed the original percentage. Notice that overheads don’t go up in proportion to sales, instead the percentage goes down when the business owner has been successful in getting more from the same.
I’ve calculated the percentage at the higher level of total overheads. When you’re doing it, you do it at the level of every different kind of overhead and measure performance at THAT level.

Disclaimer

The information contained within this factsheet is factual but may contain opinion and express different ways of considering the topic.
No responsibility is accepted by NGM Accountants for any losses or profits foregone by acting on or refraining from acting on any information contained within this factsheet or any factsheets to which this refers.
Before making any decisions concerning the accounts of your business or enterprise, you should consult a professionally qualified accountant.
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